China opening up would be positive

In this post, we’ll talk about how inflationary pressures are easing even further. Since last post, more good data was published in this area. Then we look at retails sales and Walmart's result and finally the state of the Chinese economy. A possible easing of the country's COVID policy would be a positive development, although it doesn’t seem to happen overnight. If the “world's factory” wasn’t shut down every other day, it would probably ease inflation and boost stocks.

Before the main topics, let me remind you again of the muted reaction of equities to geopolitical risks. A missile exploded on the Polish side of the border, which of course raised fears of escalation between NATO and Russia. Of course, a possible nuclear war is no cause for a bull rally. Talk of rising risks in Europe resurfaced. I am no expert on geopolitics, but my understanding is that no one wants such an escalation, and everything is done to avoid it. Europe's prospects are suffering from years of energy crisis and its structural impact on competitiveness.

What I know for sure is that investors have a short memory. Fear quickly gives way to greed. When the war in Ukraine started, a lot of thought was given to whether Finland's risk premium would increase. The thing is, war and such are tragic things, bad things, but their impact on stocks is limited. Even without dividends, Nasdaq Helsinki has actually performed marginally better than the world index or the S&P 500 this year.

 

Inflationary pressures are easing

More reassuring inflation data came out of the US on Tuesday. Producer inflation measures price developments for producers, such as industry. Producer prices rose by 0.2% in October, below expectations. Core inflation was -0.1%, but let's not pop the champagne bottle just yet. This busy graph shows both annual and monthly changes in producer prices. These also seem to be receding, which bodes well for equities.

It’s also worth mentioning that one of the many economic indicators monitored, the Empire Manufacturing Index, which measures manufacturing sentiment in New York State, was in the black in November—contrary to expectations. I don't really bring up these more local sorts of indicators, but this just happened to tie in nicely with my latest post on how the US economy seems to be doing much better than expected.

Building on that, retail sales growth also exceeded expectations in October. Excluding sales at gas stations, sales increased by 0.9% per month. However, the figures are nominal and price increases are certainly partly driving that growth. Still, this doesn’t provide immediate support for any talk of recession.

In general, the performance of the retail sector has been mixed. For example, Home Depot's sales growth has been driven by price increases, not unit sales growth. Walmart, the world's largest retail giant, reported better-than-expected third-quarter results and managed to contain inventory growth. Inflated costs and unsold goods left on the shelves were a big problem in the spring. I understand that part of the reason for the successful turnaround has been the fact that Walmart has been able to attract higher-income people to its meme stores. The company also confidently raised its guidance for the full year, although earnings are still expected to fall by 5-6% in continuing operations.

Where Walmart succeeded, another retail giant Target did not. Target's results were well below expectations and the company warned that in the current quarter, revenue could even fall for the first time in a long time. To my understanding, Target sells more discretionary consumer goods, which is why it saw its sales soften, especially in the last few weeks of the third quarter.

Btw, note how the GDP Now inched up to 4.4 % after the retail sales data.



China's economic pressures are growing

One factor that may have partly boosted equities recently has been speculation about an easing of China's harsh interest rate policy. The country has fallen into a loop, where ineffective domestically developed vaccines fail to protect citizens and the Communist Party has come up with a solution of drastic closures. This in turn has hit the economy hard. It's hard to spend and work if you can't get out of your own home. Therefore, Chinese equities have enjoyed a violent rally recently, as have COVID infection statistics.



Among other things, China is adopting a more relaxed approach to passenger testing and quarantines. But, as the authorities have already pointed out, this is mainly a “fine-tuning” of COVID policy, not a fundamental change.

However, recent economic data suggests that it may soon be time to turn coats on the politics.

Industrial output grew sluggishly in October, but retail sales fell by half a per cent, against expectations. As I have repeated many times, in the big picture, China desperately needs to rebalance its economy towards a more consumption-led one. However, so far this reform has remained on the sidelines. Every time a country's industry grows faster than consumption, the economy basically goes in the wrong direction. And this happens month after month.



There is no reason to expect a quick fix for the Chinese economy, as the bull in the room—the massive property and over-investment bubble—hasn’t been removed from the china shop either. At most, people have noticed it standing there awkwardly amid all the expensive things.

The authorities have indeed announced support measures for the real estate sector, such as a reduction in home buyers' equity and tricks to ease the liquidity situation for property developers. The pile of problems is compounded by the fact that, for decades, the only savings for ordinary people have been their homes. It’s hard to get your own citizens to spend more when their most important asset class by far, their homes, are going down in value.  This graph shows how investment in the country's real estate sector changes from year to year and month to month. They are currently falling at an annual rate of almost 10%.



When an asset class rises decade after decade, a huge amount of financial and speculative activity is built on its perpetual rise, as people sort of get used to the idea. In this case, housing prices were to rise forever. This graph shows the monthly and annual price development of new residential buildings in 70 major cities. Currently, the annual price change is negative. It will be interesting to see what implications this has for the world's second largest economy should the bubble wealth of its citizens go into a more permanent slide. Japan has taken decades to digest its own real estate bubble. It's also difficult to see how such a bubble can be digested without great pain to the economy, even with whatever relief measures are taken. You can sweep problems under the carpet for a while, but someone always ends up with the bill.



The opening up of the Chinese economy, if it ever actually happens, should be positive for the world economy. It will provide a better basis for correcting the country's economic imbalances, as citizens could have the courage to spend more. Secondly, it would remove the uncertainty hanging over the country's supply chains. In many ways, China is a global factory whose quarantines are felt everywhere. A relaxation of COVID policy should help to curb inflation in the rest of the world.

Of course, the opening up of China could also fuel commodity inflation. Global oil production capacity is already tight. The country's oil consumption may fall slightly this year, although it’s still quite close to peak levels. This graph shows monthly average Chinese consumption in millions of barrels. However, commodity inflation is a one-off bounce if it doesn’t feed wage inflation. In this sense, one might think that the opening up of China would be more of a positive driver of inflation than a negative one. However, I am not an expert on the subject and am open to a different interpretation as well.



The world's most successful investor in absolute terms, Warren Buffett, doesn't seem too bothered by the economic or political risks in China: the investment conglomerate he heads, Berkshire Hathaway, has reportedly bought a light $5 billion worth of Taiwan Semiconductor Manufacturing Company shares. It's a Taiwanese company, of course, but it also has some production in China and China is known to put pressure on Taiwan to become part of China.

The semiconductor sector is critical in almost every aspect of life, from computers to data centers and from cars to electronics. Long-term growth prospects in the cyclical sector are very promising.

TSMC has been properly punished along with the rest of the semiconductor sector. There was a huge shortage of semiconductors during the pandemic, until recently the situation has gone in the opposite direction, with some warehouses overflowing with graphics cards. This is how, in a market economy, shortages are quickly followed by overcapacity. But Buffett often invests in high-quality companies with good long-term prospects on the cheap when investors are focused on short-term concerns.

 
Pentti Jokinen made a good point on Twitter about how people are perhaps overly concerned about TSMC's China risk. After all, Berkshire's largest single holding, worth over a hundred billion, is Apple. In turn, Apple is totally dependent on TSMC, which is the sole producer of the company's chipper. China is an important market for Apple's iPhone sales.



In this sense, Buffett's portfolio weighting is a good illustration of the interdependence of the world's major economies. Both China and the US—in fact the whole world economy—would grind to a halt if something happened to Taiwan's semiconductor industry. I'm not sure that people really think that much about the supply chain risks of the listed companies they own and the risks of their own subcontractors. Perhaps it would be worth taking at least a moment to reflect on this.

Thank you for reading the post! Read analysis and make good stock picks!